Sunday, May 17, 2009

Cloud computing is often associated with “commodity” pricing and efficiencies of scale, which is why the transition to a world with cloud resources harks back to the emergence of public utilities and mass manufacturing. Cloud networks may provide a utility of sorts, but there was never an industry-wide transition from in-house electricity generation to public utility, which is what is likely to happen with cloud computing. Furthermore, while standardization and interoperability has created a layer of abstraction between applications and their underlying data center infrastructure, clouds are far from offering any service as fungible as commodities, like water and electricity. History should provide some insight into what to expect from the emergence of cloud computing, but this industry parallel from 100 years ago is not ideal.

In reading and speaking to people in the industry, I have come to the conclusion the transition to cloud computing will most resemble the transition in the semiconductor industry, as it went from fully owned fabrication facilities(fabs) to third party foundries. At first glance, this might seem silly, but let me explain.

When foundries first emerged in the 1980’s, it was in response to both the rising cost of fabs, and the emergence of many small, independent silicon design companies that had difficult financing their own manufacturing facilities. At the time, integrated device manufacturers(IDM), like TI and Intel, developed all of their own process technologies and manufactured at their own fabs. But as the global market for semiconductors grew and process technology advanced, many of the smaller IDMs were unable to keep up with the innovation necessary to remain competitive. Each new geometric process node raised the cost of fabs from $100m in 1985 to $1bn in 1994 (when the Fabless Industry Association was created) to an estimated $10bn today, making it prohibitive for only the very largest companies. Over time, even those that could afford to build a new fab found that the ebb and flow of semiconductor demand, combined with the difficult of capacity forecasting, rendered these operations highly inefficient over the long run, and a real distraction from their core business in the short run.

The emergence of foundries like TSMC offered an alternative for large silicon vendors who had difficulty managing their growth and costs. For small vendors, the impact was just as great, as the foundry model became essential for the emergence of the fabless industry, and companies like Nvidia, Qualcomm, Xilinx and Broadcom. As with any outsourcing transition, the resistance was led by arguments about IP leakage, and the strategic importance of owning and controlling their manufacturing as a competitive advantage. But such myopic views became a costly gamble with some chip companies ultimately buckling under the weight of their fab operations, and others simply ceding market leadership to their more nimble, fabless competitors.

The foundries that succeeded did so by building massive and highly efficient facilities, working closely with the process companies and leading customers. Today, the industry has only five or six leading foundries, with a handful of niche players using specialization to eke out an existence. While quality and the maturity of the technology process is critical, price is still the key determinant in choosing one foundry over another.

In thinking about the analogy I first want to point out the every growing investment required to launch a large-enterprise data center, which has risen to $500 million, from $150 million, over the past five years[1]. Additionally, the cost of running these facilities is rising by as much as 20 percent a year, partly due to the price of electricity, but also due to general opex. Secondly, due to the lead time required to design and build large data centers (2 years), capacity is added well in advance of actual business needs, forcing enterprises face a difficult task in forecasting data center requirements. For some of enterprises, data center spending is rapidly getting out of control as new data intensive applications for internal and external purposes consume valuable resources with an uncertain economic return.

While foundries and clouds provide very different services both solve a similar build vs outsource decision for their customer base. Both provide their customers with access to cutting edge technology, with minimum up front commitment, and the ability to scale infinitely at variable cost. In the case of the foundry business, there are relatively low switching costs and most large chip vendors give their business to multiple foundries to reduce risk and improve pricing. Thus far, there appears to be a similar dynamic with cloud services and their customers, but its still early days.

So what can we learn from the history of the fabless/foundry industry? The first is that due to the economies of scale required to stay competitive in terms of quality, technology and price, there are likely to be only a few big winners(aside from niche and local players). This is an issue, as most large hosting and managed service providers will make an attempt to morph into cloud service providers, with consolidation the likely result. Secondly, it will become harder and harder to justify continued spending on internal data centers as costs spiral out of control with an unclear ROI.

Finally, if there are only a few large players ten years from now, making a business selling hardware and software to these players may be harder than we think. I am reminded of the fact that despite the enormous annual capex of Google, few companies can claim to have built their success around selling to Google. On the contrary, Google has been building its own servers, and is now rumored to be building its own switches, in both cases buying off-the-shelf chips. Whether this will continue is a big question, and I am still undecided. After all, in the foundry business there is a clear distinction between companies like TSMC and Applied Materials, but this could be where the analogy fails.

In any case, one clear opportunity is to be the "fabless start-up" of the cloud era, taking advantage of cutting edge, third party data center technology and infrastructure to build a new businesses with a superior cost structure.

Friday, May 15, 2009

It is no secret that the costs of launching an Internet or software company have come down dramatically in the past decade, due to new programming languages, open source software, and ever declining server and bandwidth costs. At Bessemer, we actually calculated that cost of launching a web site application declines 50% every 18 months… one key reason we favor companies that leverage the web.

Much like the broadband build-out race of the last decade, today we see a host of companies prepared to spend billions to build out data centers(aka “clouds”) which they aim to resell as a monthly service. While some technology companies may profit from selling into these cloud networks with core infrastructure, such as management software and virtual appliances... many more will find their fortunes by properly leveraging this massive investment by others(even if some cloud companies ultimately go the way of some quixotic broadband companies).

On the face of it, cloud computing and storage services like Amazon Web Services, Joyent, Nirvanix and Mosso, are yet another example of the ever declining cost curve for web start-ups. However, cloud services are riding their own steep cost curve as these massively scalable data centers reach economies of scale and deploy cutting edge technologies becoming far more efficient, responsive, and flexible than anything known in the hosting business. The upshot is that start-ups will be able to craft their own virtual data center and pay a monthly fee only for what they use. Many of the initial customers of these services are in fact Web start-ups, but most are simply using clouds to cut costs or offload peak demand. In the coming 18 months, I expect to see many more business plans that rely heavily on this incredible resource, previously available to only the most well financed in the industry.

Lower start-up infrastructure costs will enable entrepreneurs to test more innovative product concepts, many of which were previously prohibitive from a cost standpoint. Many of these new product concepts will also involve experimenting with daring business models that can upend the established order. On this latter point, I anticipate we will see start-ups using the cheap data center infrastructure to give away more products and services that might otherwise have been paid for. Not unlike web start-ups today, these companies would then recoup their infrastructure costs and profit through premium versions and/or through lead generation revenue models. I will admit there is a fine line and overlap between your typical Web or SaaS company and start-ups that I consider to leverage the cloud. Lets just assume that in the latter case, the start-ups' product concept or marketing/distribution strategy rests even more heavily on rapidly declining computing and storage costs. Panda Security’s recent release of a free anti-virus solution might be one such example, as are the free desktop in the cloud service of G.ho.st.

In many instances, successful cloud applications will be those that are able to put a premium face on a commodity infrastructure in order to benefit from an ever widening price differential. In other words, these companies will use their own technology innovation to deliver proprietary service or application, while enjoying the ever declining costs of the cloud infrastructure. I don't refer to the myriad online storage and file sharing vendors, but new services that marry their own intellectual property to a commoditized cloud infrastructure. There aren’t too many examples just yet, but IT Structures , HD Cloud and Ctera are several companies that come to mind, and are worth watching closely.

This is the first of several posts I intend to write on cloud trends, as it the intersection of some of the dominant growth trends in today's technology market, including SaaS, Web applications and data center consolidation/virtualization.

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The thoughts and opinions expressed herein belong to the author and do not necessarily reflect those of Bessemer Venture Partners or any of its affiliates (“Bessemer”). The material here is written on the author’s own time for [his/her] own reasons and Bessemer has not reviewed or approved the information herein. Any discussion of topics related to Bessemer or its investment activities should not be construed as an official comment of Bessemer.